The economic uncertainty resulting from the COVID-19 pandemic has made it more difficult for buyers and sellers to agree on what to expect from businesses in the future, and how much to pay for that today. These differing expectations need to be reconciled for deals to get done.
Business valuations can do that by demonstrating how the broad range of issues that comprise the “narrative” of a business’s strategy and tactics can be converted to numbers.
Risks and rewards
The numbers fall into the categories of risks and rewards. Rewards are quantified in terms of the expected timing and amount of a business’s future cash flows. Risks quantify the uncertainty associated with those expectations in the form of a valuation multiple.
Risk and reward are estimated by combining expectations regarding economic conditions with expectations about how those conditions apply to the business’s narrative. Cash flows reflect the business’s expected growth, profitability and capital intensity. The capital markets identify the price of uncertainty in the form of valuation multiples that reflect investors’ risk tolerance.
Stable economic conditions combined with a stable narrative make it easier for buyers and sellers to agree on the potential rewards from a business, because the history of actual rewards is known and such conditions only reflect typical risk levels.
The range of potential future risks and rewards widens as either economic conditions or the narrative become less stable, and past experience becomes a less reliable guide. The range is widest when both become less stable as occurs during economic disruptions like the COVID-19 pandemic.
Economic disruptions can have both short- and long-term effects. Short-term effects could include additional resources that may be required to compensate for slower collections, supply disruptions, operating losses and incremental capital expenses.
Long-term effects could include changes in the expected growth rate, profitability and capital intensity of the business due to business model changes or product/service substitution effects. The absence of benchmark historical data for both cash flows and economic conditions introduces additional risk to the analysis.
All other things being equal, investors will compensate for that additional risk by using a lower multiple.
A business valuation can help to show the ability of a business to change its scale by combining the effects of fixed and variable costs with production capacity. It can also highlight the contribution from what are frequently the most valuable assets for most businesses — their customer relationships, brand and assembled workforce.
The buyer’s ability to make operational improvements and/or realize specific synergies may also be considered. Synergies are the incremental rewards resulting from combining a seller’s assets with a buyer’s complementary assets like marketing, operations and financial resources. These types of analyses can provide a better understanding of the relationship between the risks and rewards of alternative courses of action.
Finally, business valuations can model deal structures like earn-outs, which can help bridge remaining differences in expectations.
An earn-out is a risk allocation mechanism for the acquirer wherein the purchase price is contingent on the future performance of the business. The acquirer pays a portion of the purchase price at closing, with the remainder contingent on the business’s subsequent performance.
Business valuations can help to reconcile divergent expectations of buyers and sellers by demonstrating how the broad range of issues that comprise the “narrative” of a business’s strategy and tactics can be converted to numbers.
They accomplish this by considering expectations for the business’s expected growth, profitability and capital intensity in the context of the business’s historical performance, potential changes a buyer could make and expected economic conditions. They can also be used to model the effects of deal structures like earn-outs that accommodate unresolved differences.
The interaction between the internal dynamics of a business and its external environment is complex under normal circumstances. Economic disruptions add to that complexity.
Experienced valuation professionals can help buyers and sellers see eye to eye by guiding them to and through the issues that have the biggest impact on valuation by asking the right questions, finding all the necessary support for the answers, and reflecting the result in a clear and credible analysis.
Chuck Faunce is the director of business valuation & litigation support at Gorfine, Schiller & Gardyn.